ADDIS ABABA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

Capital Structure Decision on Company Success in Case of Awash International Bank s.c

A RESEARCH PROPOSAL SUBMITED TO THE DEPARTMENT OF ACCOUNTING

AND FINANCE IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR BA
DEGREE IN ACCOUNTING AND FINANCE

PREPARED BY: ABEBAW DEBIE

ADVISOR: DEREJE TEFERA

ADDIS ABABA, ETHIOPIA

Table of Contents

CHAPTER ONE.......................................................................................................................................... 1

Introduction................................................................................................................................................. 1

1.1 Background of the study.................................................................................................................... 1

1.2 Background of the organization......................................................................................................... 2

1.3 Statement of the Problem................................................................................................................... 3

1.4. Research Questions........................................................................................................................... 3

1.5. Objective of the study....................................................................................................................... 4

1.6. Significance of the study................................................................................................................... 4

1.7. Scope of the study............................................................................................................................. 4

1.8. Limitation of the study...................................................................................................................... 4

1.9. Research Design................................................................................................................................ 5

1.9.1. Research approach...................................................................................................................... 5

1.9.2. Research Type............................................................................................................................ 5

1.9.3 Sources of data............................................................................................................................ 5

1.9.4 Data collection tools.................................................................................................................... 5

1.9.5 Data analysis tools....................................................................................................................... 5

1. 9.6. Organization of the study.......................................................................................................... 6

CHAPTER TWO......................................................................................................................................... 6

2. LITERATURE REVIEW..................................................................................................................... 6

2.1 Capital structure decision................................................................................................................... 6

2.2 The Role of Finance in Company Performance.................................................................................. 7

2.3 Sources of Finance............................................................................................................................. 7

 2.4Capital Structure Theories................................................................................................................... 8

2.4.1 Modigliani and Miller (M and M) Theory with No Tax...............................................................8

2.4.2 Capital Structure In The Presence of Taxes.................................................................................8

2.4.3 Trade off theory......................................................................................................................... 10

2.4.4 Pecking order theory................................................................................................................. 10

2.4.5 Agency theory........................................................................................................................... 11

2.5 Valuation of the firm........................................................................................................................ 11

2.6 Financial distress.............................................................................................................................. 12

2.7 The Comparative cost of Debt and Equity........................................................................................ 13

2.8 Effect of Capital Structure Decision on the Success of the Companies.............................................16

2.8.1 Effect of Leverage (Debt Financing)......................................................................................... 16

2.8.2 Effect of Equity Financing........................................................................................................ 17

2.9 Capital Structure Evidence and Implication.....................................................................................17

Chapter Three............................................................................................................................................ 21

3. Research Methodology...................................................................................................................... 21

3.1 The Research Design........................................................................................................................ 21

3.2 Source of Data................................................................................................................................. 21

3.3 Sample Techniques and Sample Size............................................................................................... 21

3.4 Method of Data Collection............................................................................................................... 21

3.5 Data Analysis and Presentation........................................................................................................ 22

3.6 Cost and Time budget...................................................................................................................... 22

3.6.1 Time budget.............................................................................................................................. 22

3.6.2 Cost budget............................................................................................................................... 23

References............................................................................................................................................. 24
 CHAPTER ONE

Introduction

1.1 Background of the study

One of the main objectives of firm management is to maximize the wealth of owners or
shareholders of the firm. This objective could be achieved by making rational financial
decisions regarding optimal capital structure, which would minimize its cost of capital.

According to Gitman (2003), capital structure is the mix of long-term debt and equity
maintained by the firm, and it is generally believed that the value of a firm is maximized
when its cost of capital is minimized. The optimal structure is the combination of debt and
equity that will minimize the firm's cost of capital and hence maximize its profitability and
market value. Most of the effort in the financial decision-making process is centered on
determining the optimal capital structure of a firm. However, the decision on the level of debt
to keep relative to equity is a significant challenge for firms.

Without a planned capital structure, companies may fail to economize the use of their funds.
Hence, managers should select the capital structure that they think will have the maximum
firm value because it will be advantageous to the success of the company. Basically, banks
engage in finance inter-mediation to ensure efficient mobilization and disbursement of funds
to the real sector of the economy. Activities pertaining to the economy's total supply and total
demand fall under the real sector. According to Burser (1981), cited by J. Alloy Niresh
(2012), the capital structure decision of a bank is similar to that of a non-financial firm,
although there are considerable inter-industry as well as inter-company differences in the
capital structure of firms due to the unique nature of each industry or company. Therefore,
studying the capital structure decision on company success is important to determine the
optimal decision that leads the company to success and the different factors that contribute to
reaching the best decision.

1
1.2 Background of the organization

According to its website (HTTP//:www.awashbank.com), Awash International Bank S.C. is

the pioneer private commercial bank in Ethiopia after the downfall of the military regime and
the introduction of the market economy in 1991. On November 10, 1994, it received its
license after being founded by 486 original shareholders with a paid-up capital of br24.2
million. It started its banking operations on February 13, 1995. The bank was named after the
popular river "Awash," which is the most utilized river in the country.

The number of shareholders and paid-up capital has continuously increased and currently
reached over 4,369 and Birr 5.87 billion, respectively. Currently, Awash Bank is the first and
only private bank to build and operate in its own headquarters at the hub of what is growing
into the Ethiopian financial district. The bank has over 700 branches spread throughout the
country, thus boosting the wider branch network, making Awash Bank the leading private
bank in branch network.

The mission of the bank is "to provide modern, efficient, competitive, diversified, and
profitable banking services at domestic and international banking levels to a continuously
growing number of customers in a socially responsible manner." Its vision is "to be the
strongest and most preferred bank of the people."

Integrity, professionalism, dynamism, excellence, accountability, impartiality, team spirit,

and social responsiveness are the core values of the bank, and the main objectives of the bank
are:

I. To meet the needs of the emerging private sector for quality and dependable domestic
and international banking services.
II. To expand and diversify commercial banking services in response to the growing
demands of customers.
III. To contribute towards the economic and social development of the country and to
operate profitably in a sustainable manner.

2
1.3 Statement of the Problem

The capital structure decision is a critical aspect of finance that directly impacts the success
of a business. However, many companies struggle to determine the optimal capital structure
point, which requires careful consideration and investigation. Internal and external financing
are the two alternatives available to firms. Choosing internal financing results in a low level
of debt, which can expose the firm to takeovers that could be financed using the firm's debt
capacity. Conversely, relying heavily on debt results in high financial risk and the potential
for the firm to fail to meet interest and/or principal payments on debt. Additionally, each
financing alternative has its advantages and disadvantages.

The pecking order theory suggests that external financing decisions could signal
overvaluation to investors, leading them to sell their stocks and causing the firm's value to
decline.The study aims to determine which decision should come first and identify the
optimal capital structure decision point that leads to company success under different
circumstances. Modigliani and Miller's propositions demonstrate that the capital structure is
relevant for determining the value of firms, and the introduction of corporate taxes allows
firms to deduct interest on debt in computing taxable profit (Modigliani and Miller, 1958,
1963). This suggests that tax advantages from debt would lead firms to be completely
financed through debt. However, this proposition does not align with reality and leads to the
argument for the relevance of bankruptcy costs.

Therefore, the study aims to investigate the effect of capital structure decisions on company
profitability and answer the following research questions:

1.4. Research Questions

I. Does the capital structure decision have an effect on company success?

II. What is the optimal capital structure decision point that gives the best alternative to
the company?
III. What factors lead to the determination of the best optimal decision?

3
1.5. Objective of the study

The primary objective of the study is to identify the effect of capital structure decision on
company success. In particular, the study incorporates the following specific objectives:

1. To find an optimal capital structure that leads the bank to be successful.

2. To identify the factors determine the optimal capital structure

1.6. Significance of the study

The study is supposed to create a good understanding about the effect of capital structure
decision on the company success. This research will not only for the financial manager of
Awash bank Share Company but it will have a great implication for other companies. And
also, it will have an advantage for other researchers by locating hints to work more.

1.7. Scope of the study

The study is focusing on capital structure decision on company success as much as possible
in case of Awash international bank Share Company.

1.8. Limitation of the study

The study is limited to analyzing the impact of capital structure decisions on the success of a
company. The research will focus on internal and external financing options available to
firms. The study will not investigate other factors that may influence a company's success,
such as market competition or economic conditions. Additionally, the study's findings may
not be generalized to all types of companies, as factors such as industry and size may play a
role in capital structure decision-making. Finally, the study will only consider the perspective
of the company and may not take into account the interests of other stakeholders.

4
1.9. Research Design

1.9.1. Research approach

This study will be conducted through both qualitative and quantitative techniques. The
researcher will not use complicated quantitative techniques rather simple numeric operations
will be performed on the data analysis.

1.9.2. Research Type

Descriptive research design will be used in this study. The reason why such method adopted
is to properly identify and describe the optimal capital structure decision and the different
factors that determine the optimal capital structure.

1.9.3 Sources of data

The study will include primary and secondary sources of information. Use of both primary
and secondary data findings enhances the fairness and transparency of the result.

1.9.4 Data collection tools

For each data type different tools will be selected. Primary data will be collected through a
questionnaire which has a kind of structured and unstructured character. The reason why such
kind of questionnaire used for is to enhance the question clear, straightforward, to enable the
respondent think freely, to save time, and to make idea easy. On the other hand secondary
data will be collected from financial reports of different periods of the bank, from books,
from research documents that has been done earlier and from websites.

1.9.5 Data analysis tools

The data obtained through questionnaire and secondary data will be analysed and presented
by using tables, percentages, ratios, and charts.

5
1. 9.6. Organization of the study

The research report will be organized in four chapters, namely: chapter one deals with
introduction and background of the study, chapter two is about literature review, chapter
three, will encompasses data analysis and presentation and the last chapter will present
conclusion and recommendation.

CHAPTER TWO

2. LITERATURE REVIEW

2.1 Capital structure decision

Capital structure is the mix of long term debt and equity maintained by the firm. And it is the
most complex area of financial decision making because of its interrelationship with other
decision variables. Expansion in revenue necessitates growth in operational capital, which
frequently necessitates raising external cash through a combination of debt and equity. The
firms mixture of debt and equity may vary somewhat over time, most firms try to keep their
financial mix close to a target capital structure. (Ehrhardt and Bringham, 2010:PP.559).

Capital structure decisions can have important implication for the value of the firm and its
cost of capital. Poor capital structure decision can lead to an increased cost of capital there by
lowering the net present value(NPV) of many of the firm’s investment project to the point of
making many investment projects unacceptable(known as under investment
problem).Effective capital structure decisions will lower the firms overall cost of capital and

6
raise the NPV of investment projects leading to It will be more acceptable to take on
additional projects, raising the firm's worth overall (Gitman,2003).

2.2 The Role of Finance in Company Performance

Finance plays an important role in the operations of firm. Financing decisions involve
determining optimal liquidity whether for working capital or investment purposes. According
to Smith, (1980) cash is “king”. Without cash many operations will come to a standstill.
Customers and suppliers will lose confidence and collapse of the business is likely. Suppliers
lost confidence in the company and as a result, it could not secure material or funds from
Banks. (Machange, 2003:pp.96-97)

2.3 Sources of Finance

Having, established the need for finance, the company will have to evaluate different sources
available for raising required finance .In general terms. Companies have two broad sources of
finance –internal and external sources. When funds rise externally, entrepreneurs should
choose between issuing debt or equity. (Robert and Rechardo, 1996:pp.186).

Most of the effort of the financial decision making process is centred on the determination of
the optimal structure of a firm. In other words, it involves choosing the best debt to equity
ratio. (Modigliani and Miller, 1958, 1963: pages 437).These sources have been examined by
researchers to determine their cost and preference. Debt financing is often more preferred
than equity as equity issues deliver a bad message to shareholders. Although, it is convenient
and relatively simple to raise finance through debt, there is some limitation to the alternative.
(Machange,2003:pp.97).

For example both debt and shares can be traced in the secondary market. This process, known
as securitization, allows holders to exchange securities whenever they need to. Firms can also
raise finance through securities on the strength of existing assets. The market efficiency
assumptions assist in and efficient allocating of resources. This is achieved through firm’s
interaction with forces and the managerial supervision exercised. The result is timely
commercial and financial decisions directed towards meeting shareholders objective of profit
maximization. Finance is a scarce resource; its availability can be costly. There is need to

7
analyze the finance foundation in order to enhance the value of the firm and consequently
shareholders wealth. More importantly, determining the optimal level of finance and sourcing
is the fundamental task of management, which should be carryout without prejudice to other
functions. Existence of different sources gives companies alternative for evaluating cheaper
source and hence adopting the one with optimal benefit to the company. (Machange,
2003:pp.97).

2.4Capital Structure Theories

2.4.1 Modigliani and Miller (M and M) Theory with No Tax

This section explores the famous arguments of Modigliani and Miller made in 1958. They
maintain that under special conditions the choice of capital structure has effect on the firm.
The authors (M and M) assume that capital markets are perfect and that there are no taxes. A
perfect capital market is the one in which all investors can borrow and lend funds at the same
interest rate.

Having shown that neither VL>VU nor VL<VU are equilibrium relationships, the only
equilibrium result is to have VL=VU.

Where; VL=Value of levered firm

VU=Value of unlevered firm

Equivalently, in the absence of taxes, otherwise identical levered and unlevered firms must
have the same value. When two firms differ on their capital structure, they must have the
same value. Therefore, the firm’s levered decision is irrelevant to the value of the firm. It is
important to remember, though, that we reached this conclusion under the assumptions of
perfect capital markets and no taxes. When we remove these assumptions, capital structure
decisions may affect the value of firms. ( Robert and Rechardo,1996:pp.186-189).

2.4.2 Capital Structure In The Presence of Taxes

Modigliani and Miller demonstrated in their second proposition that introduction of corporate
taxes allowed firms to deduct interest on debt in computing taxable profits. This suggests that

8
advantages derived from debt would lead firms to be completely financed through debt. The
fact this later proposition is not in accordance with the reality leads to the argument for the
relevance of bankruptcy costs. Corporate taxes associated with other costs could therefore
explain observed debt to equity ratios. Introduction of tax in to the capital structure theory
forced firms to seriously consider the possible impacts of bankruptcy costs. This gave rise to
the trade off theory maintains that companies equate the marginal benefit of an additional unit
of debt with the associated marginal costs, holding constant the firm’s assets and investment
plans. (Modigliani and Miller, 1958,1963).

We began considerations of capital structure in the real world by analyzing the effect of taxes
and deductibility of the firm’s interest payments. We continue to assume that capital markets
are otherwise perfect. Since firms may deduct all interest payments, it seems that firms
should use a great deal of debt. To see why we must recognize that there are three claimants
to the firm’s EBIT: stockholders and debt holders and the government. Since the stockholders
and debt holders are the only investors in the firm, to increase its market value the firm
showed reduce the government’s tax share whenever possible, thus delivering a greater
portion of its EBIT to stockholders and debt holders. The firm can do this by choosing
different capital structures. (Robert and Rechardo, 1996:pp.190-192).

Suppose there are two firms, unlevered (U) and levered (L) that have identical assets
producing the same cash flow every year (The cash flows of both firms may be uncertain, but
they must be perfectly positively correlated). The two firms differ only in their capital
structure firm U has financed its assets solely with stock, so it is unlevered, whereas firm L
has financed its assets with a combinations of debt and equity, so it is a levered firm.

If the value of firm L is greater than the value of firm U, the investor who owns the equity of
firm L can take advantage of the difference in value by selling the shares in L, borrowing
some additional funds, and using those funds to purchase the shares of firm U. These
translations will leave the shareholders who originally owns firm L better off. Since firm U
itself is unlevered but the investor’s position is levered, this is an example of investors trading
to create homemade leverage where investors can personally create any capital structure by
transferring in the market place. (Robert and Rechardo,1996:pp.186-189).

9
2.4.3 Trade off theory

This theory says that the value of levered firm is equal to the value of any side effects, which
includes the tax shield and the expected cost due to financial distress.(Ehrhartdt and
Bringham, 2010:pp.610).

An important purpose of this theory is to explain the fact that corporations usually are
financed partly with debt and partly with equity. It states that there is an advantage to
financing with debt, the tax benefits of debt and there is a cost of financing with debt. the
costs of being in financial difficulty, including bankruptcy costs and charges not related to
bankruptcy. When deciding how much debt and equity to utilize for financing, a corporation
that is maximizing its overall value will pay attention to this trade-off because the marginal
benefit of additional increases in debt drops as debt increases while the marginal cost
increases.

2.4.4 Pecking order theory

According to this hypothesis, the cost of funding rises as knowledge becomes more
asymmetric. A firm may raise capital in a pecking order if flotation costs and asymmetric
information are present. In this situation, a firm raises capital internally by reinvesting its net
income and selling its short-term marketable securities. The company will issue debt and
maybe preferred stock once that source of funding is depleted. Only at last resort will the firm
issue common stock. (Ehrhardt and Bringham,2010). This theory maintains that businesses
adhere to hierarchy of financing sources and prefer internal financing when available, and
debt is preferred over equity if external equity is required. In other words, the firms financing
decision follows order of accessibility and cost. Internally generated cash flows are the
cheapest form of finance; debt is the next most expensive form. To minimize the total cost of
fund, firms use the cheapest fund source first. But, because internal funding sources are
constrained, businesses are frequently compelled to turn outside of their own walls to the
credit and equity markets and pay the premiums associated with these outside resources. The
choice between debt and equity is governed by the kind of information each transmits to the
market. In a market where there exists information asymmetry, issuing debt may signal that
the firm has a good project. On the other hand, equity capital issuance may signal that the
firm has bad one.

10
2.4.5 Agency theory

The agency theory is a different theory that is employed to forecast the best structure. An
agency relationship is established because shareholders and corporate management are
separate. The agency problem is a circumstance when there is a conflict of interest brought on
by this. According to the agency problem, whilst managers seek their own best interest,
shareholders will be expecting them to work towards maximizing the value of their
investment. We discover that the outcome of these conflicting interests can eventually
forecast the ideal capital structure. The agency problem leads to indiscriminate expenditure
by managers who have enough cash at their disposal. Ehrhardt & Brigham's assertion from
2009 that management may have enough money to spend on their favorite projects rather
than on value-maximizing projects supports this. For instance, managers with extra money
may spend it on glitzy offices, corporate jets, and such items that don't accomplish much to
increase shareholder wealth.

2.5 Valuation of the firm

The value of a firm’s operations is the present value of its the present value of its expected
future free cash flows discounted at its weighted average cost of capital(WACC). The WACC
depends on the percentage of debt and common equity, the cost of debt, the cost of stock, and
the corporate tax rate. (Ehrhardt and Bringham, 2010:pp.559).

In a market economy, determining the value of the firm is fairly simple as securities are
traded and the equilibrium price established becomes the security price. The value of the firm
may also be estimated by investor from financial statement. These are prepared by the
director to show their accountability for the resources with which they have been entrusted.
Being the agents, they have to show that they are implementing their duties satisfactory. This
is manifested through the ability of the company to pay dividends continuously. This
accountability has influenced their role of reporting to shareholders. Creative accounting
which was prominent in 1980’s was the manifestation of agency theory. A value of the firm
can be determined by looking at the future cash flow potential. One valuation model of the
firm looks at the future dividend stream, using the dividend discount model. The formula
used in discounting the dividends.

11
P=∑Dt (1+R) t

P= the current shares price

Dt= dividend paid in time t

R=the return earned in the capital market on securities

With constant dividend growth

P=d∕(r-g)

Where g =the dividend growth rate

For quoted shares, the price can be determined as prospects, because r dividend payments
will affect the expectation of investors and consequently the price. Directors as agents, try to
insure share price is preferred as it signifies profitability and growth of the firm. Investors
will be willing to pay the price which equates the present value of future dividend payments
and growth potential discounted at the appropriate cost of capital. (Machange, 2003:pp.102-
104).

2.6 Financial distress

Financial distress arises when the financial obligation of the firm affects the firm’s normal
operations. There are many degree of financial distress. The ultimate kind of financial
distress is bankruptcy, a condition in which the firm is unable to meet its obligation.

By assuming the markets were perfect (except for taxes), we implicitly assumed that financial
distress and bankruptcy were costless. For example, if markets were perfect, bankruptcy
would be costless in the sense that up on declaring bankruptcy, the firm could immediately
sell its assets and transfer to them to some other productive employment without tax. (Robert
and Rechardo, 1996:pp.193).

Generally speaking, when a company's debt increases, the likelihood of financial trouble and
eventual bankruptcy increases as well. An excessive reliance on debt capital results in a debt
crisis where a company struggles to make debt payments. The company will eventually file
for bankruptcy if corrective actions are not implemented in a timely manner. A credit rating

12
agency may reduce the credit rating of companies or even entire nations that are experiencing
a debt crisis. In light of the fact that a downgrade implies a diminished capacity to repay debt,
this could possibly make their condition worse. Lenders will therefore be reluctant to lend
such an organization some more.

Financial stress has a number of rippling impacts. The risk associated with a firm in financial
distress frightens shareholders who demand higher returns. As a result of shareholders'
increased demand for larger returns, equity costs rise. Shareholders investments become more
risky because they are only entitled to a residual after the debt holders have been paid
(Ehrhardt& Brigham, 2009). This raises the price of equity during tough financial times.
Also, when firms are in financial difficulties their value and profitability fall because of the
fear of bankruptcy and the costs that go with it move the shareholders to dispose even at the
lowest price immediately of their shares. As a result, the firm's worth and profitability are
decreased during the difficult financial times. It is also important to realize that during
financial distress, the cost of debt may also increase (contrary to the general view that debt is
cheap) which also reduces profits before tax. This might happen due to the fact that creditors,
also perceiving the possibility of the company’s inability to pay them, demand higher interest
rates. Hence, debt costs will increase, and profitability will decline. Other effects of
increasing company’s leverage as explained by Ehrhardt & Brigham (2009) include the
possibility of falling free cash flows and profitability because customers perceiving risk could
take their business elsewhere. On the other hand, employees start to worry about their
existing positions and lose crucial time working on finding or considering future jobs.
Suppliers also tightens their credit standards resulting in falling accounts payable and
increasing net operating working capital which in turn reduces cash flows (Ehrhardt&
Brigham, 2009).

The above analysis shows that despite the tax advantage of debt, increasing debt to equity
ratios can bring grave consequences for the firm. So, companies must carefully raise their
debt-to-equity ratios while keeping in mind the danger of insolvency. As a result, businesses
are discouraged from taking on excessive debt.

13
2.7 The Comparative cost of Debt and Equity

Management always strives to obtain a combination of both and equity that maximizes the
value the firm (Machange , 2003). The cost of raising finance through equity is referred to as
the cost of equity, whereas that arising from debt is the cost of debt (Machange , 2003).The
cost of debt and equity to the firm is the equilibrium rate of return required by investors.

The key benefit of debt is the tax deductibility of its servicing cost. The main cost of
additional debt is bankruptcy risk and the costs associated with such bankruptcy. Those costs
could include the direct costs of re organization in the event of insolvency as well as indirect
costs that arise when companies get in to financial difficulty.

It should be emphasized that compared to internal funding sources, which may be used
practically instantly, debt has delayed access and greater transaction expenses. This might
cause people to prefer internal resources to debt. Some may prefer to maintain information
asymmetry. There is no requirement to subject the company to external review if internal
funds are utilized. Similar to this, when debt financing is used, information is disclosed to
bankers, but neither the capital market nor competitors or shareholders are required to receive
it. A fund cost hierarchy may be produced as a result of the benefits of privacy and the
expenses of information disclosure. Lastly when new equity is issued to new owner, it may
dilute the claims of existing shareholders.

However, a caveat that must be placed is that there are significant costs associated with
extreme reliance up on a single fund source.

The cost of capital is the sum of the individual cost of debt, cost of equity and cost of
retained earnings (Machange, 2003).Common stock (ordinary shares) are riskier, and hence
the rate of return tends to be higher for extra risks assumed. The average cost of capital is the
weighted sum of components; Cost of capital and it is calculated as follows:

WACC=rd (1-T)*D/V+re(E/V), where:

rd=cost of debt.

T=the corporate tax rate.

14
D=the debt of the firm.

V=the market value of the firm as determined by stock market.

E=the equity.

re =the cost of equity.

WACC is the traditional approach adopted in measuring the cost of capital using proportions
of components to the market value. (Machange, 2003:pp.102-105)

According to Ehrhardt and Bringham, 2010 these equation shows, the only may any decision
can change a firm’s value by affecting either free cash flows or the cost of capital. Below
some of the ways that a higher proportion of debt can affect WACC and free cash flow (FCF)

Debt increases the cost of stock, rs

Debt holders have a claim on the company’s cash flows that is prior to shareholders, who are
entitled only to any residual cash flow after debt holders have been paid. The fixed claim of
debt holders causes the “residual” claim of the stock holders to become riskier, and this
increases the cost of stock, rs.

Debt reduces the tax of a company payment

Consider a company's cash flows as a pie that is divided up among three separate groups. The
firm piece goes to the government in the form of taxes, the second goes to debt holders, and
the third to shareholders. Companies are able to deduct interest costs from taxable income,
which lowers the government's share of the pie while increasing the amount available to
investors and debt holders.

The cost of debt rises due to the possibility of bankruptcy.

The likelihood of experiencing financial hardship or possibly bankruptcy rises as debt grows.
With higher bankruptcy risk, debt holders will insist on a higher interest rate, which increases
the pie-tax cost of debt, rd.

15
The net effect on the WACC

WACC is a weighted average of relatively low cost debt and high cost equity. The weight of
low-cost debt (Wd) rises and the weight of high-cost equity (Ws) falls as the proportion of
debt increases. If all else remaining the same, then the WACC would fall and the value of the
firm would increase.

Charging the capital structure affects all the variables in the WACC equation, but it is not
easy to say whether those changes increase the WACC, decreases it, or balance out exactly
and thus leave the WACC unchanged. (Ehrhardt and Bringham, 2010:pp.559-561).

2.8 Effect of Capital Structure Decision on the Success of the

Companies

2.8.1 Effect of Leverage (Debt Financing)

Fig 2.1 Effect of leverage (Debt financing)

16
The tradeoffs model is summarized graphically in the above figure according to Bringham,
2009).The top graph shows the relationships between the debt ratio and the cost of debt, the
cost of equity, and WACC. Both rs and rd (1-Tc) climb steadily as leverage rises, but the rate
of growth quickens as debt levels rise, indicating agency costs and the likelihood of financial
distress rising. The WACC initially decreases, then reaches a minimum at D/V*, and finally
starts to increase. Keep in mind that D*, the amount of debt in the lower graph that
maximizes the firm's value, is the value of D in D/V* in the upper graph. Thus, a firm’s
WACC is minimized and its value is maximized at some capital structure. Be aware that the
general forms of the curves hold true whether we use the miller model, the modified MM
with corporate taxation model, or a combination of these models. Unfortunately, it is
impossible to quantify accurately the cost and benefit of debt financing, so it is impossible to
pinpoints D/V*, the capital structure that maximizes a firm’s value. Most experts believe
such a structure exists for every firm, but that is changes as firms operations and investors
preferences change. Most experts also believe that, as shown in the above figure, the
relationship between value and leverage is relatively flat over a fairly broad range so large
deviation from the optimal capital structure can occur without materially affecting stock
price.

2.8.2 Effect of Equity Financing

Investors and managers have different levels of knowledge about a company's future due to
asymmetric information. Further, managers try to maximize value for current stockholders,
not new ones (Bringham, 2009). Therefore if the firm has excellent prospects, management
will not want to issue new shares, but it things look bleak, and then a new stock offering
would benefit current stockholders. Consequently, investors take a stock offering to be a
signal of bad news, so stock prices tend to decline when new issue are announced. New
equity financings are consequently fairly pricey. The net effect signalling is to motivate firms
to maintain a reserve borrowing capacity designed to permit future investment opportunities
to be financed by debt if internal funds are not available.

17
2.9 Capital Structure Evidence and Implication

Studies show that firms do benefit from the tax deductibility of interest Payments, with
atypical firm increasing in value by about $0.10 for every dollar of debt. This is much less
than the corporate tax rate, which supports the Miller model (with corporate tax and personal
tax) more than the MM model (with only corporate taxes). (Ehrhardt and Bringham,
2010:pp.618)

The financing choice of existing firms might be influenced by their past financing choices
and by the cost of the moving from one capital structure to another, but Managers are free to
choose a capital structure for spin-offs since they are brand-new businesses. The study found
that more profitable firms (which have a lower expected probability of bankruptcy) and more
asset-intensive firms (which have a better collateral and thus a lower cost of bankruptcy
should one occur) have higher levels of debt. These findings support the trade-off theory.

Yet, there is also evidence that runs counter to the trade-off theory's assumption of a static
optimal target capital structure. For instance, because stock prices fluctuate, a firm's real
market-based debt ratio regularly deviates from its aim. The corporations involved do not,
however, instantly issue or repurchase securities in order to return to their aim. Instead, firms
tend to make a partial adjustment each year, moving about one-third of the way towards their
target capital structure. This evidence supports the idea of a more dynamic trade-off theory in
which firms have target capital structure but don’t strive to maintain them too closely.
(Ehrhardt and Bringham, 2010:pp.618)

Firms issue equity much less frequently than debt. On the surface, this seems to support both
the pecking order hypothesis and the signalling hypothesis. The pecking order hypothesis
predicts that firms with a high level of informational asymmetry, which causes equity
issuance to be costly, should issue debt before issuing equity. Yet we often see the opposite,
with high-growth firms (which usually have greater informational asymmetry) issuing more
equity than debt. Also, many highly profitable firms could afford to issue debt(which comes
before equity in the pecking order) but instead choose to issue equity with respect to the
signalling hypothesis consider the case of firms that have large increase in earnings that were
unanticipated by market. Managers will foresee these impending performance improvements
and issue loans before the increase if they have superior information. Such firms do in fact

18
tend to issue debt slightly more frequently than other firms, but the difference is not
economically meaning full. (Ehrhardt and Bringham, 2010:pp.618-619)

Many firms have less debt than might expect, and many have large amount of short-term
investments. This is especially true for firms with high market or book ratio (which indicate
many growth options as well as informational asymmetry). This behaviour is consistent with
the hypothesis that investment opportunities influence attempts to maintain reserve borrowing
capacity. It is also consistent with tax consideration, since lode-growth firms (which have
more debt are more likely to benefit from the tax shield). (Ehrhardt and Bringham,
2010:pp.619)

Implication for managers

Managers should explicitly consider tax benefit when making capital structure decisions. Tax
advantages are undoubtedly more important for businesses with high tax rates. Firms can
utilize tax loss carry forwards and carry backs but the time value of money means that tax
benefit are more valuable for firms with stable, positive pre-tax income. As a result, a
company with reasonably constant sales can comfortably take on more debt and pay greater
fixed costs than one with erratic sales. Other things being equal a firm with less operating
leverage is better able to employ financial leverage because it will have less business risk and
volatile earnings.

Managers should also consider the expected cost of financial distress. This depends on the
probability and cost of distress. Notice that stable sales and lower operating leverage provide
tax benefits but also reduces the probability of financial distress. Loss of investing prospects
is one cost of financial turmoil. Firms with profitable investment opportunities need to be
able to find them, either by holding higher level of marketable securities or by maintaining
excess borrowing capacity. The potential need to liquidate assets in order to meet liquidity
needs is another cost of being in financial crisis. Unlike to special-purpose assets, general
purpose assets that can be employed by a variety of enterprises are reasonably liquid and
constitute appropriate collateral. Thus, real estate companies are usually highly leveraged
where as companies involved in technological research is not. (Ehrhardt and Bringham,
2010:pp.620)

19
Asymmetric information also had bearing on capital structure decisions. For example,
suppose a firm has just successfully completed a research and development program, and it
forecasts higher earnings in the immediate future. However, the new earnings are not yet
anticipated by investors and hence are not reflected in the stock price. This business should
finance with debt rather than issuing stock until the higher earnings start to show up and are
reflected in the stock price. The capital structure might then be restored by issuing common
stock, paying off the debt, and retiring the debt. Managers should consider conditions in the
stock and bond markets. For instance, during the most recent credit crunch, there was no
longer a market for new long-term bonds tied to BBB at a "fair" interest rate. Therefore, low
rated companies in need of capital were forced to go to stock market or to the short term debt
market, regardless of their target capital structure, when conditions, however these companies
sold bonds to get their capital structure back on target.

Finally, managers should always consider lender’s and rating agencies. (Ehrhardt and
Bringham, 2010:pp.620-621)

20
 Chapter Three

3. Research Methodology

3.1 The Research Design

The case study will focus on Capital Structure Decision on Company Success in Case of
Awash International Bank s.c. In order to achieve the research objective both qualitative and
quantitative (or mixed research approach) is adopted the reason for the use of such mixed
method approach together is that data could not be obtained by adopting a single approach.

3.2 Source of Data

The study will include primary and secondary sources of information. Use of both primary
and secondary data findings enhances the fairness and transparency of the result.

21
3.3 Sample Techniques and Sample Size

The method of sampling techniques will be use judgmental sampling techniques to select a
sample from employees, because to save time and cost effectively. Because of few numbers
of top management employees who process capital structure decisions Questionnaires are
distributing to 15 finance coordinate senior accountant of Awash international bank s.c.to
collect the primary data.

3.4 Method of Data Collection

For each data type different tools will be selected. Primary data will be collected through a
questionnaire which has a kind of structured and unstructured character. The reason why such
kind of questionnaire used for is to enhance the question clear, straightforward, to enable the
respondent think freely, to save time, and to make idea easy. On the other hand secondary
data will be collected from financial reports of different periods of the bank, from books,
from research documents that has been done earlier and from websites.

3.5 Data Analysis and Presentation

The data obtained through questionnaire and secondary data will be analyzed and presented
by using tables, percentages, ratios, and charts.

3.6 Cost and Time budget

3.6.1 Time budget

No Activity to Month
be make
Dec Jan Feb Mar Apr May June July

1 Research 
title
selection

22
 2 Problem  
identificatio
n

3 Literature 
review

4 Proposal 
submission

5 Design data 
tool

6 Collecting  
data

7 Analysing 
data

8 Finishing 
data

9 Submission 

3.6.2 Cost budget

Item Description Measurement Estimated budget ( Birr)

Print and Stationary materials Page 200

Photocopy paper Page 50
Transportation Frequency 50
Telephone Air time 50
Coffee and tea Person 150

23
Other miscellaneous expense No 100
Total 600

References

1. Awash international bank profile. Accessed from, www.Awashinternationalbank.com.

[Accessed date, 12-04-2015]

2. Awash international bank financial records. Accessed from

www.thebankerdatabase.com/indx.cfm...[Accessed date, 13-06-2015]

3. Awash international bank records. Retrieved from www.addisfortune.net/articles/awash-

international...[accessed date,13-06-2015]

4. Betty Machange. (July 2003), corporate Finance, African Journal of Finance and
management, Vol.12

5. Ehrhardit and Bringham (2010), financial management theory and practice.

6. Eugene F.Bringham and Louis C.Gapenski (2007). Financial management theory and
practice, 6th edition.

24
7. Gitman.L.J.(2003) principles of managerial finance. Boston: Addison weslay

8. J. Alloy Niresh,(2012).Capital structure decision and profitability. Retrieved from

www.en.wikipedia.org/wiki/capital structure. [Accessed date, 16-04-2015]

9. Modigliani, F.Miller.M (1958) corporate income taxes and cost of capital: A correction
American review.

10. Myers.S and Majluf.N (1984). Corporate financing and investment decisions. Journal of
financial economics, retrieved from www.books.wikipedia.org/financial... (Accessed date,
12-04-2015)

11. Pandy, I.M (2009), financial management: capital structure planning and policy.
Retrieved from, www.books.google.com/books/about/financial…[Accessed date, 15-06-
2015]

12. Robert W.and Rechardo J. (1996), Financial Management, 2nd edition.

25